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TRANSFORMERS OR AESOP’S FABLES? ONE RATING AGENCY’S LOOK AT FLORIDA

Columbus, Ohio, May 14, 2019: Recently the Florida legislature enacted, and Governer DeSantis will sign, Omnibus Prime, perhaps referencing the chief robot of the Transformers, Optimus Prime. One provision doubled an insurer’s loss adjustment reimbursement provided by the Florida Hurricane Catastrophe Fund from 5 percent to 10 percent of loss. In the 2019 session, HB 7065 was passed. Despite 7 previous years of failed efforts, Assignment of Benefits reform may be in place to move Florida toward the otherwise national standard for claims procedures.

No one expects Florida’s bad actors to pack it in; however, even a partial reversion to the national standard for claims practices could lower the Sunshine State’s loss and loss adjustment costs meaningfully. Demotech applauds these measures, vigorously advocated by Demotech and other stakeholders since 2013. Mending the fractured Florida judicial system was critical to the stabilization of insurers’ claims paying capability, particularly in the event of catastrophic events. Concurrently, these measures were necessary to reverse the continued rise in consumer premiums.

While the extent to which these CAT Fund and AOB savings will not be known with certainty for years, it is a certainty that exposure to catastrophic event risk is now significantly lower. The cost of reinsurance providing claims paying capability to insurers in the event of catastrophic events should be priced based on a view of risk which reflects these recently enacted measures.

At Demotech, our ratings reflect risk and insurers’ ability to manage it. Risk is not static and therefore Demotech’s process continually evaluates and re-evaluates our own internal view of risk. Months ago, Demotech issued guidance as to the quantity and quality of catastrophe reinsurance based on our (then) view of risk. A view that reflected the social inflation of AOB in conjunction with the relatively low CAT Fund LAE reimbursement for the (then) existing level of social inflation. The aforementioned legislative reforms had not been factored into our view of risk.

It is clear that carriers focused on residential and commercial property insurance in catastrophe prone jurisdictions such as Florida require significant amounts of reinsurance in the event of a catastrophic event or a series of catastrophic events. However, these same carriers also require a net premium level to support their obligations to honor meritorious attritional claims unrelated to catastrophic events and defend against those that are not. In establishing and assigning Financial Stability Ratings® (FSRs), the cost of reinsurance factors significantly into the FSR assigned to the primary carrier. In other words, if a primary carrier can afford to purchase its reinsurance program but does so to the detriment of its ability to address attritional claims obligations, the FSR of that carrier cannot be sustained at the current level.

So … we transition from Omnibus Prime and a reference to Transformers to Aesop’s Fables, the man who owned a goose that laid a golden egg. Each day he gathered the egg, sold it at a fair price and used the funds to offset his daily purchases, including a portion for his savings. Following this practice, he remained secure for years. However, one day, he decided to go big by cutting open the goose and gathering up all of the golden eggs right now.

When the owner of the goose compared living comfortably to living extravagantly and opulently, he choose the latter. We know how the fable ends – there was no accumulation of golden eggs inside the goose. Rather, the goose possessed the capability to produce a secure and comfortable lifestyle by laying a single golden egg per day. The owner of the goose should have stuck to his business model. Greed turned a sustainable plan into economic disaster.

Although Florida sustained three hurricanes in the past three years, it has also been the case that Florida has sustained but three named hurricanes in the past thirteen years. Additionally, Florida CAT reinsurance rates, being relatively low in the tower of reinsurance purchased, command the highest price for risk. To strain the metaphor, Florida focused insurers are the gaggle laying golden eggs for reinsurers: private, public, insurance linked securities (ILS), catastrophe bonds, etc.

Sustaining Your Reinsurance Business Model

Several times a year, insurers take to the road for their obligatory reinsurance roadshows including visits to Demotech, where insurers have made qualitative presentations upon which reinsurance underwriters can form a view of risk, and price the account accordingly. In Demotech’s opinion, we have rarely observed meaningful pricing differentiation imposed upon Florida focused insurers.

The responses of Florida focused carriers to the storms of 2016, 2017 and 2018 present those same reinsurance underwriters with quantitative data to supplement the qualitative data they have heard for nearly a decade. Which carriers have walked the walk that they described over the past decade? If 2019 reinsurance costs fail to discern between the primary insurers that walked the walk versus those that talked the talk, the valuable information available from the reality of the impact of the storms of 2016, 2017, and 2018 may have been collected for naught.

With institutional capital invested in property CAT risk in the form of ILS (admittedly a bit bruised and fatigued by the events of 2016 through 2018 yet also far from exiting the market) capacity remains in place. Ironically, after perhaps the worst three years of property CAT losses globally, capacity in 2019 remains solid. This is a stark contrast to the response following 2004 and 2005, when capacity, particularly for CAT prone risk, dropped markedly.

From a consumer’s perspective, personal lines automobile insurance (35% of the US insurance marketplace) and homeowners insurance (nearly 20% of the US marketplace) have been commoditized. If reinsurers and ILS fund managers fail to price differentiate carriers and the reinsurance protection that they purchase, they may boost short-term profit; however, they will further contribute to the commoditization of catastrophic risk, concurrently, dis-incentivizing primary insurers to outperform the mean.

Florida-focused primary insurers are a hardy and adaptable group whose behavior is influenced by their returns on effort. Without the incentives that only price differentiation can bring, what is the motivation for primary insurers to undertake roadshows, implement loss mitigation initiatives, enhance data quality, and reward their clientele with appropriately differentiated premium levels?

Reinsurers are a valuable source of capital – human and financial – for primary insurers. However, they own no geese and must associate themselves with those who have the ability to produce a periodic golden egg. Aesop warned of the fallacy of cutting open the goose.

The storms of 2016 to 2018, FHCF reforms, and Omnibus Prime brought reinsurers three important tools for 2019 pricing that that they did not have for 2018 pricing:

Unquestionably, some reinsurers recognized and factored these into their discussions, deliberations, and deliverables. Those that have not yet done so may want to reread Aesop’s Fable and heed its moral – it is foolish to be greedy. Or in the words of Optimus Prime – “In any war, there are calms between storms. There will be days when we lose faith.”

With steps forward from the fractured judicial and financial metrics of the past headed toward signature by Governor DeSantis, Demotech’s resultant view of CAT risk will factor in our view of primary insurers’ total risk, balancing the price and quantity of the reinsurance they secure.

About Demotech, Inc.

Demotech, Inc. is a financial analysis firm specializing in evaluating the financial stability of regional and specialty insurers. Since 1985, Demotech has served the insurance industry by assigning accurate, reliable and proven Financial Stability Ratings® (FSRs) for Property & Casualty insurers and Title underwriters. FSRs are a leading indicator of financial stability, providing an objective baseline of the future solvency of an insurer. Demotech’s philosophy is to review and evaluate insurers based on their area of focus and execution of their business model rather than solely on financial size. Visit www.demotech.com for more information.